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The Shadow Bankruptcy System

This article exposes and explores a puzzle at the heart of the current economic crisis: The surprising under-use, and increasing misuse, of Chapter 11 of the United States Bankruptcy Code, the principal legal system for salvaging troubled businesses.

Like the "shadow banking" system for which it is named, shadow bankruptcy thrives on and promotes opacity and undisclosed, possibly perverse, incentives. Shadow bankruptcy players exploit regulatory gaps to conceal their identities and motives, and so increase the uncertainty, complexity - and thus the cost - of negotiations to restructure distressed firms; they burden judicial resources through internecine fights of little benefit to reorganizing debtors; they have complex, multi-faceted hedging strategies that may effectively short-sell the debtor's reorganization effort, resulting in depressed asset values and the premature liquidation of otherwise viable firms.